Re:Balance -- Jim Peterson

What Price Wrong-Doing? Sanctions Against KPMG Are Complicated

It's always a pleasure to be a guest at Going Concern -- where the post below appears as of this morning, looking at two front-burner topics this summer in the US and the UK. For a detailed review of the threatening and volatile environment in the UK, where official actions threaten the stability of the Big Four business model and the viability of their franchise to audit large public companies, I invite you to my new book, available on Amazon in paperback and e-reader formats -- "DOA: Can Big Audit Survive the UK Regulators?

“Sell in May and go away” was an investors’ adage invoked as vacation strategy in a more genteel era. Returns in the summer were said to lag the rest of the year—and in any event, that’s how brokers justified their holiday cottages on the eastern seaboard.

This year the maxim has twice failed my attempt to stay off the grid. Most visibly, the SEC on June 17 ordered a $50 million fine against KPMG LLP; the penalty was a two-fer: both a complement to the criminal proceedings against senior personnel of the firm and the PCAOB for the theft and misuse of agency inspection information, and also for the firm’s gaming of internal training and tests, including those done under prior orders of the SEC itself.

Also there is the inquiry in the U.K. into the “purpose of audits,” led by former London Stock Exchange chair Sir Donald Brydon, under a charge from Greg Clark, Secretary of State for Business, Energy and Industrial Strategy—latest in a series of official proceedings involving the Big Audit model, inspired by a series of scandals originating with the January 2018 collapse of the giant public contracting enterprise Carillion.

Sir Donald’s convocation of two diverse advisory groups, and his upbeat Twitter note that his Call for Views in April elicited 110 responses, provide optimism that the project will not only look at the expectations of the capital markets for an audit model fit for modern purpose, but also assess the realities, weaknesses, and challenges in the existing market dominance of the Big 4.

Uncertainties around KPMG’s punishment connect the two. The link is the under-appreciated fragility of the Big 4—the shockingly low ceiling on the financial capacity of the firms to survive a fine or judgment on the scale that Enron inflicted on Arthur Andersen, because another collapse would put at risk the entire model.

A $50 million fine against KPMG is not itself of that magnitude. Spread among the roughly 2,200 partners of the U.S. firm, with its 2018 revenue on the order of $9 billion, the bearable impact is about $23,000 per partner. (The LLP does not disclose profits per partner, but a comparison with the disclosed 2018 partner profits of the KPMG network’s firm in the U.K.—£601,000, or about $765,000, is probably reasonable.)

Skepticism about the size of the hammer wielded by the SEC has come from well-recognized critics: in the U.S., Jason Bramwell at Going Concern, Matt Kelly at Radical Compliance, Francine McKenna at MarketWatch; in the U.K., twittering academics @premsikka and @atulshah among others.

Which is not unfair. A fine of even $100 million would not raise the individual impact above $50,000 each for the average KPMG LLP partner.

But the critics’ argument for a fine of $1 billion, nearing $500,000 per partner, would be another matter. That would be seriously painful and, if doubled, would raise the existential challenge that insecure partners would swallow their loyalty, withdraw their capital, and vote with their feet—throwing the firm and its entire global network into an Andersen-like death spiral.

Theoreticians and policy-makers concerned with crimes and punishments have agonized over the complexities: What level of sanctions properly balances society’s desire for deterrence with the appropriate pain on a wrong-doer? How well is justice served, where collateral concerns—here, the survival of the Big Audit model itself—put a practical ceiling on the ability to punish?

If the problems with money fines are intractable, what other tools are available? The SEC’s June 17 order (paragraphs 65 to 82) includes a basket of multiyear reviews, reports and undertakings by leadership of KPMG LLP, and requires the engagement of an independent consultant.

Enough to satisfy the critics? If those impositions are too light to be credible, suppose creation of an office of the CEO, with C-suite presence of outsiders on a day-to-day supervisory basis.

The idea that senior management be supplanted by outside leadership has been advanced at least twice—first in 2002, as Arthur Andersen lurched to its collapse, with the non-starting notion that the eminent Paul Volcker should step in, and again in 2008 as a proposal of the Advisory Committee on the Auditing Profession convened by Treasury Secretary Henry Paulson.

Both met understandable ridicule and rejection. The powers of a newly-arrived corporate CEO to hose the stables might be effective—wholesale firings and reorganizations would be well within scope. Not so, as Andersen’s experience demonstrated, where a partnership’s viability depends on retention of the skills, votes, and mutuality of trust and confidence among a committed collection of partners.

“Solutions” either facile or intemperate being unhelpful, here are offered two desires:

First, that for the sake of their credibility, the critics should be obliged to annotate their harsh rhetoric with constructive proposals by which to replace the current Big Audit model, which the draconian penalties they urge would threaten to destroy.

Second, that Sir Donald Brydon’s review will have sufficient breadth to embrace the entire array of inter-connected issues, including the survivability of the Big 4 model for privately provided large-company audits.

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Ukraine’s Bank Regulator Whacks PwC – As For The Broader Messages?

The 103^rd anniversary on June 28 of the assassination of Archduke Ferdinand in Sarajevo, with the consequent world-wide descent into the maelstrom of warfare, should remind that under aligned conditions, “distant and obscure” does not mean “benign and inconsequential.”

 It was reported in the Financial Times on July 20 and the KyivPost on July 21, 2017, that the National Bank of Ukraine – the country’s banking authority – has struck PwC’s firm from its bank auditor registry. The alleged failure:

“to highlight the credit risk faced by PrivatBank PJSC, which led to the bank being declared insolvent and nationalized, with substantial recapitalization costs borne by the state.”

To the charge of failing to identify a $ 5.5 billion balance sheet hole, PwC issued the expected statement of disappointment: “PwC performed its audit of PrivatBank’s 2015 financial statements in accordance with international auditing standards” – typical language in private litigation, but of cold comfort as the firm faces loss of its Ukrainian bank audit franchise.

PrivatBank starkly displays the “Expectations Gap,” at its worst. That is, even a GAAS audit assumed to be immaculately compliant with professional standards would not remotely satisfy the hindsight pique and anguish of an immature small-country regulator, forced to hoover up the droppings of a political crony’s quasi-private piggy bank.

My response to a media inquiry on the implications in Ukraine, and more broadly for the Big Audit model, gathered these notes, here at more length than a broadcast soundbite permits:

First, as hostage to the NBU, PwC’s plight illustrates the accounting profession’s hazard where government as enforcer also has a client’s direct financial interest. That is, whatever PwC’s virtuous claim to good work, the firm cannot simply dig in and litigate, as it would against a private plaintiff, because its adversary controls its very right to practice.

Examples abound. From bygone days was Arthur Andersen’s travail with its Belfast audit client DeLorean Motor Company – because the major investor was the British government. There, HMG not only sued the audit firm when DeLorean collapsed in 1982, but it also black-listed Andersen from auditing British government enterprises and agencies, inflicting the crippling loss of a portfolio of actual and potential future work. (Full disclosure – I was a senior in-house counsel at Andersen at the time, with involvement in the unpleasantries.)

Second, there are potentially disruptive consequences to Ukraine’s banking sector – depending on the extent of PwC’s market share and the availability of replacements. (While the website of PwC Kyiv states that among its industry services, it is “particularly focused on the banking sector,” a table as of 2011 shows PwC in a fairly distant third place among the Big Four.)

Even if not an issue in Ukraine, a harbinger of potential larger concerns is the uneven distribution of audit expertise in the major economies. Consider, that is, the disruptive impact on available auditor choice in Germany if KPMG were to lose its license there, as it audits almost half of the country’s DAX 30 companies, or if PwC in the United Kingdom were excluded from auditing its 40% share of the FTSE 100.

Third, there are operating implications for PwC beyond Ukraine. It will lose whatever cross-border work it does for the subsidiaries and affiliates of home-country institutions outside Ukraine; and it will also be challenged to conduct audits for foreign banks with Ukrainian operations requiring audits under the NBU’s authority – needing to seek out the resources in-country either from the other Big Three or among whatever cross-border banking expertise may reside in other, smaller firms.

Finally, there is the large-scale question of the stability impact on the Big Audit model. In the bigger picture, Ukraine is not big enough to matter – PwC could simply shut down there without significant impact on its global business. Not so, however, if a regulator in a seriously large economy were to do the same – because loss of license in a G20 country -- on the scale of Spain or France or Italy, or surely Germany or Japan or the UK or the US – would mean a network-wide failure of client service capability. That would speedily disintegrate an entire Big Four network – with disruptive impact on the entire Big Audit model, incapable of functioning with only Three members.

Andersen’s virtually overnight downfall in 2002 is illustrative – to serve its large-company clients on a global basis, a Big Four network cannot operate anywhere if it cannot operate everywhere.

The scale and gravity of PwC’s issues in Kiev should not be under-stated. The writing on the wall may be devilish hard to read, being in Ukrainian, but its meaning is both clear and ominous.

 

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Guest Op-Ed: Should FSOC Designate the Big Four As “Systemically Important”? How Not – And Yet Then What?

The question above, about the definition and scope of large bank regulation, may seem a bit wonk-ish. Unless you happen to be a large bank officer or director -- or a bank regulator – or maybe a bank client -- or a bank’s auditor or other gate-keeper.

Welcoming all readers to a new year that promises to be full of challenges, this topic kicks off 2017.

I am pleased to pose the question as co-author with Bill Kring, senior academic researcher at Boston University’s Center for Finance, Law & Policy, at today’s blog BankThink, published by The American Banker and dealing with ideas, trends and other developments in financial services:

“Efforts to mitigate the impact of systemically important nonbanks on the global economy have largely omitted a sector deeply entangled with financial institutions across the capital markets: the big accounting firms.

“The Financial Stability Oversight Council (is) mandated by the Dodd-Frank Act to designate ‘systemically important financial institutions’ for bank-like regulation….

“While FSOC’s future authority is somewhat in doubt as President-elect Trump sets to take office and the GOP has maintained control of both chambers of Congress, the work of regulators to contain systemic risks is no less important. And they should turn their attention to the ‘Big Four’ auditors that, despite being nothing like a bank or a broker-dealer, provide the audit opinions legally-mandated for all of the SIFI-designated institutions (emphasis added).

(For the entire piece, please see BankThink for January 9, 2017.)

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Of Crimes and Punishments -- And Where Shall Justice Be Found?

 A quiet summer holiday in a mountain village – time to ponder last month’s note from an always-thoughtful reader, on the news that Msgr. William Lynn, then secretary for clergy in the Catholic archdiocese of Philadelphia, had been convicted of child endangerment for allowing priests accused of child molestation to be moved from parish to parish. He asked:

“How is it that the Catholic Church and its senior hierarchy have not also been indicted?”

The question resonated for two reasons. The first was poignant, because the questioner is a retired partner of the Arthur Andersen accounting firm[1] – perhaps the single global institution in the last decade to have paid with its own life for individual wrongdoing at its senior levels. 

The second is the still-unfolding question of sanctions for the global banks, starting with the multi-year conspiracy to rig the London interbank offered rate, which so far has include the defenestration of Barclay’s chairman Marcus Agius, CEO Robert Diamond and COO Jerry del Missier.

The three departed took hidings from the British Parliament’s Treasury Select Committee on July 4^th, 10^th  and 16^th, after the bank in late June had agreed to pay fines totaling some $450 million to the British Financial Services Authority and the US CFTC.

By settling, the bank avoided criminal charges – eliciting speculation as to whether the Libor-fixing scandal will lead to actual indictments of other banks, and querulous criticism from James Stewart of the New York Times – who is also upset about the serial mis-behavior of UBS (here).

Unlikely. With the singular exception of Andersen, the prosecutorial pattern is to allow the institutions to settle:

• Goldman Sachs threw its trader Fabrice Tourre under the government bus in 2010, over its design of a tradable hedging product designed with the input of a favored customer, escaping itself with the fine of an inconsequential $ 550 million (here).   

• The fine of $ 456 million paid by KPMG in 2005, to settle criminal charges by the IRS over its long-running tax-shelter activities, was said by those knowledgeable to have approached the firm’s survival tolerance – but an outside monitor’s supervision and a deferred prosecution agreement allowed the firm to survive and carry on. 

• The revelation of Jerry Sandusky’s decades-long abuse of young boys, under the knowingly tolerant eyes of the authorities at Penn State, cost the jobs of the president and athletic director, plus that of the theretofore sanctifiable coach Joe Paterno – as detailed in the damning report of ex-FBI director Louis Freeh – and now removal of JoePa’s on-campus statue and agreement to accept NCAA sanctions including a fine equal to a year’s football revenue, four years of post-season suspension and the bizarre “vacating” of its football victories since 1998. Thus briefly hobbled by a national sports administration arguably more influential than official law enforcement, the Penn State football program survives, and there is not a whisper of existential threat to the school itself.   

So what does it say about the societal enforcement of the responsibilities of large institutions, that they are normally spared from the ultimate penalty?

Whatever one’s belief about the proper scope of government, my reader presents a profound challenge: how can and should agencies of government act for the public good, with appropriate recognition of the limitations on their competence?

Societies decide on their behavioral norms, their tolerable limits for deviation, and their enforcement expectations from agencies of regulation and governance.

The Andersen experience may prove a rule, that the powers of law enforcement are fundamentally reluctant to threaten the life of an enterprise or institution, no matter how egregious the behavior of its principals.

The weight of anecdotal evidence would appear so.[2] And society has and uses other tools:

• As one effective sanction, the rules of the private marketplace are inexorable. Fallen leaders have taken down entire institutions, from Bear Stearns and Lehman Brothers to Merrill Lynch and MF Global. But the history is uneven: doubtful actors also survive, sometimes with government assistance but also due to the vagaries of bankruptcy and reorganization – recent examples being GM, AIG and Fannie Mae.

• Further, the lottery of civil litigation – with all its flaws, costs and uneven application – provides some reimbursement to some of the wronged – although with the slow grinding of the wheels of the courts, these will impose mainly not on the wrong-doers but on current and generations – Barclay’s current shareholders, and future Penn State students seeing larger tuitions and smaller course selections.

• Thirdly, the fragility of reputation takes its toll: Penn State will fail to attract some future students, and the Church will lose some members. Companies will change auditors, and bank clients will shift their loyalties. 

The conflicts and ambiguities in the punishment of institutions mean that “justice” is not easy to define in practice and even harder to locate and apply case-by-case. 

With that, I can only hope to hear whether this meditation nourishes the reader whose note, with my appreciation, set it in motion.   

 

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[1] Where, by way of reminder/disclosure of a chapter long closed but not forgotten, I also spent a considerable time, although ended before the firm’s death spiral that was Enron.

[2] Not least, because Andersen’s fatal indictment and disintegration can be explained, with the simplicity of Occam’s Razor, as owing to its leadership’s arrogant refusal to face its record as an unrepentant recidivist.     

 

Dimon in the Rough? Jamie Gets Up and Down with the Law-Makers

Jamie Dimon called on the Washington carpet? 

The rug was royal red and plush indeed -- judged by the treatment given to JP Morgan Chase’s chief executive by the Senate Banking Committee on June 13, and by the House Financial Services Committee a week later, over the bank’s synthetic credit derivatives “portfolio hedging” debacle publicly quantified at $ 2 billion on May 10.

Dimon’s agility at alternately seducing, evading and befuddling his interrogators was a reminder of the sadly limited capability of senior law-makers to bring meaningful leadership to the complex world of global-scale finance.

It may sound like a final examination essay for a graduate-school course in Government or Policy (and my students should consider themselves duly warned), but it truly matters out in the real world.

That’s because the depressing conclusion from the Dimon hearings is that the prospects for beneficial regulatory influence are dim.

As a “teaching moment,” C-Span viewing is not for the faint of heart, nor the weak of stomach. The participants performed with the character depth of a Dan Brown novel and a virtual inability to read their staff-drafted questions.

Fawning by the Senators -- Dimon’s home-town Charles Schumer (D-NY), or Jim DeMint (R-NC) or Bob Corker (R-Tenn) -- was only matched in the lower House by the embarrassing display of incompetence -- Maxine Waters (D-Cal), Gary Ackerman (D-NY), Brad Sherman (D-Cal) and Rubin Hinojosa (D-Texas) being selected egregious examples. 

The proceedings showed no grasp among any of the players of some basic truths, starting with this pressing question:

If a bank so ostensibly well run through the financial crisis could incur a blow-up of such magnitude, what level of confidence should be reposed in the safety of institutions not nearly as robust?

Dimon’s straight-faced assertion -- that the multi-billion dollar wrong turn in his London-based derivatives portfolio was “an isolated event” -- aimed to finesse the break-down of oversight and controls at the bank’s highest level where, as he invoked President Harry Truman, “the buck stops.”

But to accept Dimon’s embrace of the solutions of industry-wide capital and liquidity requirements – facile for him, because at levels his own bank can meet -- is to ignore the fundamental lessons of large-scale catastrophe:

Namely, it is precisely those with potentially disastrous impact – whether Japanese nuclear plant siting or Italian cruise liner routings or permissible banking activities – that are most demanding of the highest degree of attention.

The sources of learning are ominous in their two messages (e.g., the late mathematician and markets observer Benoit Mandelbrot and Black Swan populizer Nassim Nicholas Taleb):

• First, financial bubbles are inflated by the aggressive huffing and puffing of bankers acting in accordance with their basic DNA, only to burst inexorably because complex systems designed and run by humans are inherently susceptible to breakdowns beyond either prediction or prevention.

• Second, the inevitable excesses of the marketplace will always outpace the efforts of legislators and regulators operating under constraints of resources, comprehension, intelligence and constituent influence.

So, because the bankers cannot be constrained from using models and other self-deceptive devices that mask or rationalize their weaknesses, what can society expect from its regulators?

Given their inability to do more than scapegoat the last outburst with show-trial hindsight rather than anticipate the next one with perception and effectiveness, a structural response must be straightforward – recognizing both that self-interested bankers will push any regulatory scheme past the point of abuse, and that the regulators themselves lack the tools to stop them.

The comparison remains apt: If hammers are allowed in the toy-room, there will be breakage by the toddlers.

It is important that “too big to fail” has no bearing. Dimon’s “London whale” could have laid on his misguided portfolio, outside the boundaries of a permissive regulatory regime, on behalf of far smaller institutions – the rogue examples include Jon Corzine at MF Global and last fall’s Kweku Adoboli at UBS, and go back to and beyond 1995 and Nick Leeson on the Singapore fringes of Barings Bank.

What it does mean is that the repeal of Glass-Steagall’s separation of investment from commercial banking has proved catastrophically costly, enabling the kiddies to run amok with their hammers.

Which, in context of the Dimon hearings’ evidence of “boys and their toys,” should be profoundly disturbing. The rules still to come under Dodd-Frank – watered down by the on-going lobbying that Dimon claimed as the bank’s “constitutional right” – leave the bankers’ undisciplined playroom wide open and effectively unsupervised. 

 

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The Next Home for International Financial Scandal? If You Can Find It -- It's Malta

I recently made my first visit to the tiny island nation of Malta – once the Mediterranean crossroads of crusaders, smugglers, pirates and profiteers, now better known as a way-stop on the marine route of refugees fleeing coastal North Africa for near-by Sicily and mainland Italy.

My impressions -- of a country and people with much to be modest about -- leave me uneasy, with Malta now touted as headquarters to a rapidly-expanding roster of European-based hedge funds – e.g., here and here.

This is not good news. Because if true, the fuse is lit and sparking on the next explosive weapons of financial destruction.

For all its storied history, today’s Malta is a backwater. The country’s low-wage economy survives on limited tourism for history buffs, and second-language schools serving a heavy demand for English because the native tongue with its Arabic origin and Latin orthography is unlearnably complex, marginalized, and disappearing.

In by far the smallest country in the Euro zone, with a population of 400,000 mainly unprepossessing Catholics, the focus of governance is limited to the legality of divorce. While, as I was told by the under-employed college graduate who drove our taxi from the airport, ”You’ll probably never see a policeman during your visit. There’s so little crime, they go into the parks and sleep in their cars behind the trees.”

Transport on Malta until last summer’s upgrading was dominated by fleets of clapped-out orange and yellow buses, of a vintage more worthy of pre-Castro Cuba than a full-fledged member of the European Union.

The inevitable question asked by a tourist looking over the pervasively sand-colored Italianate architecture is, “Doesn’t a country with aspirations to be taken seriously care enough to wash its cars and clean the dirt off its windows?” To which the prompt and unashamedly self-deprecating answer, “who cares?” is that the prevailing winds off the African desert make a daily layer of dust as inevitable as the sunrise itself.

After centuries of outside dominance, latterly in the form of British colonial oppression until independence in 1964 and eventual troop withdrawal in 1979, a legacy of brain drain and talent flight assures a vacuum of local vision and mediocrity of leadership.

“Maltese” evokes several things – post-Crusade centuries of knightly influence, toy-sized white dogs in the laps of ladies who lunch, and the elusive avian statue that so bedeviled Humphrey Bogart’s Sam Spade in the eponymous 1941 re-make of Dashiell Hammett’s noir novel. 

What it does not call up is a legitimate industry of well-regulated financial institutions.

So what is nascent, with the explosive growth of a Maltese hedge fund sector, is dangerous regulatory arbitrage – the potential for a rush to the bottom not seen since “regulatory capture” in Antigua and Barbuda laid the foundations for Allen Stanford’s Ponzi scheming, through his purchase of a tin-plated knighthood along with the compliant gate-keepers’ keys to that country’s thatched-cottage banking industry.

The cases are legion that even big-country regulators have been asleep on the watch – from the SEC’s failure to finger Bernie Madoff, to OFHEO’s late-arriving blinking at the sub-prime mortgage trainwrecks of Fannie Mae and Freddie Mac, to the PCAOB’s belated discovery of something rotten in reverse-merger Chinese public companies coming to America to list on its exchanges.

So the chances that the Maltese have the competence to escape a worse fate, in response to the invading hordes of hedgies in their private jets and sharply tailored suits, are precisely nil.

I have been bold in this space to make an occasional prediction about the expected times and places for outbreaks of unpleasantness – in Islamic finance, a Madoff-related suicide, or the rates of white-collar recidivism exemplified by Barry Minkow’s return to prison – with a record that is almost distressingly robust. 

Readers prepared to files these views on the likelihood of serious mischief erupting on Malta into a time capsule with a three-to-five year seal are invited to check back with me then.

In the meantime, pending the passage of time sufficient to prove me right, prudence suggests that investors seek a home for their hot and mobile Euros other than Malta.   

 

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UBS: Roguery at the Bank Provides a Teaching Moment

Kweku Adoboli has done me a great favor.

Many others could not say the same. They include Oswald Grüber, Carsten Kengeter and Maureen Miskovic – the chief executive, head of investment banking and senior risk officer of UBS – whose balance sheet the 31-year-old trader has blown up to the tune of $ 2.3 billion, through the unimaginative if devastating use of fictitious customer trades to mask his massive wrong-way bets on the S&P 500 and other major indices.

While Adolboli will stay another month in custody in London, and Grüber’s team of gnomes in Zurich begin the extended process of damage assessment and control of this latest outbreak at the troubled bank, I have the privilege of bringing to a seminar at the University of Chicago Law School the MBA-level course in Risk Management I have taught at business schools these last three years.

Arrested on the third anniversary of the collapse of Lehman Brothers, Adoboli not only lets me throw out the opening pages of my introductory lecture notes, on the inevitable eruption of large-scale unmanaged risks in complex systems. He also replaces Société Générale’s Jérôme Kerviel as a final exam topic on the test question, “Where’s the rogue?” 

In the law school environment, we will explore the proposition freshly demonstrated at UBS, that compliance-oriented risk systems – limited in concept, execution and assurance to the narrow and unsatisfactory conclusion that “most things are working, most of the time” – are both wasteful and ineffective to detect or deter an existential threat.

It’s as true for a rogue trader as for a suicide terrorist: doing pat-downs or box-ticks of an entire population, whether grandmothers on airplanes or bank clerks writing customer orders, will not stop the dangerous deviant capable of causing a blow-up – however much those intrusive and costly procedures may serve the political goal of lulling both leaders and constituents into a false if harassed sense of security.

In context of Adoboli’s shenanigans, said to date back to 2008 when UBS itself was bailed out of the consequences of its ill-fated venture into subprime mortgage-backed derivatives, on through its climb-down before the Justice Department over the business of sheltering US taxpayers, there is painful irony in reading the bank’s self-congratulation on the subject of its risk management. Take, for example, excerpts from its 2010 annual report:

“Operational risk is the risk resulting from inadequate or failed internal processes, human error and systems failure, or from external causes (deliberate, accidental or natural). Events may be manifested as direct financial losses or indirectly in the form of revenue forgone as a result of business suspension. They may also result in damage to our reputation and to our franchise causing longer term financial consequences.

“Managing risk is a core element of our business activities, and operational risk is an inevitable consequence of being in business. Our aim is not to eliminate every source of operational risk, but to provide a framework that supports the identification and assessment of all material operational risks and their potential concentrations in order to achieve an appropriate balance between risk and return.

“… Management, in all functions, is responsible for establishing an appropriate operational risk management environment, including the establishment and maintenance of robust internal controls and a strong risk culture.” (All emphasis added.)

With that, a question could be posed to Mr. Grüber concerning the bank’s reported 2010 payment of fees to Ernst & Young of 67.4 million Swiss francs ($ 59 million at today’s exchange), of which CHF 58.5 million were classified as audit, to obtain the latest annual version of a standard auditor’s report:

“With hindsight, how badly would you have wished to re-direct some portion of that audit fee to an engagement to conduct a precise and effectively directed, root-and-branch scrutiny of the condition of the controls at the sections of your bank having potential to inflict multi-billion dollar harm?”

Because herein lies the puzzle, about the unavailability of such valuable assurance to replace today’s outmoded commodity product:

In launching its concept release on the auditors’ report, Public Company Accounting Oversight Board chairman James Doty’s June 21, 2011 statement acknowledged “generalized investor dissatisfaction with the pass-fail model, and generalized frustration with auditors who had issued unqualified opinions on the financial statements of banks that later failed.”

And yet -- the entire community of financial statement issuers, users, regulators and auditors remain committed to what one comment letter notes as “the PCAOB’s intent to retain the current (‘pass/fail’) form of the auditor’s report.” As stated, there is “overwhelming support from all stakeholder groups for retaining this long-standing approach to auditor reporting.”

Why?

Kweku Adoboli now stands as poster boy for the unrecognized urgency of replacing that model.

 

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Racing to Avoid a Crash: On the Track -- On the Street

There’s a stack of final papers in my Risk Management course – and an apero on the sunny terrace of the neighborhood café, to ease the grading process.

And a fond wish for one more class session, to dissect last weekend’s lesson in the disastrous consequences of bad risk assessment and choice-making under high-stress competitive conditions.

It happened at Sunday’s Indianapolis 500. Rookie driver JR Hildebrand had a comfortable lead going into the final lap. But instead of riding easily to victory, he attempted a high pass of a slower car on the very last corner, crashed into the wall, and slid his wreck to a second-place finish – passed by the doubtless astounded Dan Wheldon, on whom Hildebrand’s error of judgment and the fickle gods of fate bestowed a gift beyond imagination.

Aggressive, brave or foolish – the high cost of immature enthusiasm under “win or crash” analysis is not rare. Recall the Olympic gold medal that snowboarder Lindsey Jacobellis threw away on her final run at Turin in 2006, with her ill-advised showboating stunt attempt on the last bump.

My class of MBA and Finance students focuses on lessons from highly-consequential decisions, especially in failure situations – drawn from many fields into the worlds of commerce and professional services, where most will eventually work, and where senior leaders charged with risk responsibility have performed so poorly over the last four years.

From Hildebrand’s split-second choice – now part of racing lore and a life-long mark on his career record, they would take at least these two:

First, the skills and energy of the young are to be recognized and respected; a new hot-shot does command attention and can achieve greatness, whether in sport or government or a trading room. But as events at Indy showed, the converse is no less valid. Beginner’s luck is no substitute for seasoned strategy, and those surviving to accumulate the scars of experience bring wisdom that tempers rash choices.

Provided Hildebrand does learn his risk/reward lesson, in other words, he is not likely to repeat it.

Therein lies learning for business and financial disciplines, still struggling past the recent crisis. The tragically short time horizon of the designers of exotic derivatives, and the exclusion from the quants’ risk models of events beyond their recollection, created the conditions for the crushing impact of events erroneously thought to be unforeseeable.

The second lesson from Hildebrand’s choice-making looks at the structure of his decision matrix: a binary choice -- “try to pass” or “lay off” -- but with alternative and different benefits and detriments for each.

The consequences of playing safe and cautious were in his favor: there was no downside, as he was at no risk of being overtaken, and to cruise safely meant a checkered flag.

In choosing to charge the corner, on the other hand, he had negligible upside – he was already holding a dominant lead – while, as events proved, the downside of being unsuccessful was catastrophic.

(Take note, of course, that the calculation could alter dramatically – if, for one case, he was trailing and needed a last-minute pass to advance, or if he was tightly shadowed and at risk of losing his lead.)

The metaphor extends, readily enough:

Should an investment manager double down on a losing strategy, which unless reversed will bankrupt his fund? Or should the size of his positions be controlled along the way, so that no single exposure could threaten his entire firm’s survival?

Should an entrepreneur put all his capital at risk to start a new venture? To a retiree in reasonable comfort, the upside is limited, but the hazard of a failed and penurious old age is real; while to a new graduate with a long view, fortune favors seizing the greatest number of jackpot opportunities.

The under-appreciated risk-assessment obligation, all of this should suggest, lies in deliberate attention, usually overlooked, to the alternative choice: the action foregone, the rejected Plan B, the road not taken, the decision not to charge ahead.

To a rookie Indy driver with his hair on fire and his foot to the floor, this would all seem abstract, bloodless and pedantic. But it should feel otherwise to a risk officer whose strategic control over a floor of stoked-up traders is his bank’s best hope for survival through the next bubble.

Because my students are more likely, post-graduation, to steer companies and to run portfolios, than to drive turbocharged racing cars, the sorry case of JR Hildebrand’s impetuous mis-chance will keep a place in my curriculum.

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Holiday Gifts in Bernie Madoff's Bankruptcy: A Widow Does Her Bit -- and the Banks Will Too

 Holiday gifts arrived early in December for the circle of players around the wreckage that was Bernie Madoff. There are several lessons.

First, the widow of Madoff’s ur-client Jeffrey Picower redefined the landscape of civil forfeitures by agreeing with Madoff trustee Irving Picard to turn over an astonishing $7.2 billion – said to be her late husband’s entire take from a 35-year relationship (here).

Second, Picard himself dumped sacks of coal and lawsuits into the stockings of the Madoff enablers – notably including Unicredit, JPMorgan Chase, UBS and HSBC – charging them with notice of Madoff’s irregularities even while profiting from their proximity as custodians, administrators and managers of the monies fed to him by investors (the FT’s December series is well summarized here).

The former is of interest at least as a matter of social behavior and norm-setting. The latter will have reverberations with effect on the relationships between banks and other intermediaries and their own gate-keepers, including their auditors.

Barbara Picower faced this dilemma: She could have spent the rest of her own life defending against Picard’s suit, fighting uphill to protest the conduct and virtue of her spouse – who, charitably accepting her own claim of innocent ignorance of Madoff’s scheming, confronted the plainly demonstrable character evidence of his propensity to cheat at golf (a favorite post with readers from March 2009 is here).

Or – presumably able to live in adequate comfort on her bequest from Jeffrey of $ 200 million, and thus dramatically re-calculating the magnitude of a “widow’s mite” – she could launder her own status with a dramatic gesture of civility and largesse.

Secular sainthood is seldom so available – and with nary a hungry day either.

The noblesse of the widow Picower has made life less pleasant for Madoff’s other A-list clients. Those like Picower, close enough to finger the tattered edges of his moral fabric, are now forced to choose. They can oppose Picard’s claims to claw back their ill-gotten returns, under the shadow of the widow’s precedential capitulation. Or they can join the settlement queue – although not cushioned by the generous inheritance she enjoys, and to be seen only as belated converts, never to enjoy the halo effect she obtained as first-mover.

Depending on his trawl through Madoff’s client list, Picard is now working on a shortfall of some $10 billion. Of that, it says here that he will extract on the order of $ 1 billion from HSBC alone – precisely on account of the roadmap to its liability provided by the due-diligence engagements performed for the bank by KPMG in 2005 and 2007 and roundly ignored. It’s a plaintiff’s dream and an evidentiary nightmare for the bank that, prediction suggests, HSBC will pay handsomely to keep far away from a trial.

There’s more here, though: The KPMG engagements are a roadmap not only to what was done for its client, but to what could have been done for the other enablers targeted by Picard. Therein will lie a tale for the courts – and another set of eight or nine-figure contributions eventually to reach Picard’s collection basket.

But now for the broader questions: What if HSBC had taken KPMG’s work to heart. Or the other banks and feeder funds had engaged credible due diligence by their advisers on accounting, auditing and controls? Madoff’s pyramid would have been toppled before it reached pedestrian levels.

Suppose by extension, while we are at it, that Lehman Brothers had asked E&Y for a critical study of the exposures lurking in its use of repo derivatives to window-dress its balance sheet? And actually acted on it?

Or that Daniel Bouton at Société Générale had re-deployed a portion of his bank’s costs of external audit to give actionable scrutiny to the corrupted back-office operation that was so expensively exploited by rogue trader Jérôme Kerviel?

Or that AIG had given credence to a state-of-thinking study of the non-correlated nature of the inter-connected structure of the global CDO market?

Instead of the risk management possibilities of available but unavailed sources of wisdom, these institutions continued to subscribe to the one-page, bog-standard commoditized reports that regulators require from auditors – to be ignored in good times, because they convey no value regarding non-problematic operations, and useless for the detection and prevention of catastrophic events in bad. 

It’s a closed and obsolete system as bankrupt as Bernie Madoff himself. In the entire cast of characters, Barbara Picower emerges so far as the best of the whole sorry lot.

 

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The House of Lords Looks at the Role of Auditors: And Then Everyone Went for Tea

 Here’s a good way to increase the chances for satisfaction: start with very low expectations.

That was my approach, anyway, in dialing up the broadcast by Parliament TV of the House of Lords Economic Affairs Committee session of November 23, billed as a look at concentration in the audit market and the role of the auditors in the financial crisis -- here.

As a soporific, it was a decent substitute for televised football as a way to sleep off the after-effects of the Thanksgiving feast – watching the heads of the Big Four practices in the UK bat away slow-pitch questions that ranged from the naïve and misinformed to the incomprehensible.

Plainly, the intractable challenges to the viability of the large-company audit model are at no risk of being solved at the hands of the British legislators, whose depth of inquiry ran the gamut of complexity from A to B.

Examples:

• “Are you happy” with the degree of market concentration? Well, what’s not to like -- although it can hardly be admitted, when the Big Four control the entire large-company audit market with no prospect of competition.

• What about a threat to withdraw from the audit market? Oh, not us, your lordships – audit is at the very core of what we do!

• If that’s so, “are you uneasy” that the large firms would go from four to three?

• With a straight face, “we don’t see that on the horizon.” Of course not – while at the same time conceding that although the events of the credit crisis were “unprecedented,” there are “lessons to be learnt” for everyone.

Sometimes the unthinkable does happen – as the events of the last three years have made clear. So where was their lordships’ follow-up question: 

What would you do – what would any of us do – if despite your intentions, one of the firms incurred what was described with wonderful British euphemism as an “Andersen moment”?

And for this, there was no suggestion of an answer from either side of the tables. 

In the middle third of the proceedings, their nobilities were able to become better informed, if not wiser, as their invited guests gave a concise run-down of the irrelevance to audit concentration of a list of unachievable ideas -- namely:

• Break-up of the Big Four would add nothing to global-scale competition, since – against the breadth required because 80% of the revenue of FTSE 100 companies is generated outside the UK -- the resulting fragments would lack scale, coverage and investment capability.

• The current restriction on scope of services to audit clients – where last year no FTSE 100 company paid consulting fees to its auditor – is claimed to be working well: an assertion which, considering the unsolved nature of the survivability threat, means that if the current environment represents success, what would failure look like?

• The arguments for joint audits or mandatory rotation founder on the examples of degraded quality – the likes of Parmalat in Italy and BCCI in the UK itself.

• And the howler of the day: if audit is “implicitly a form of insurance,” why does that industry not ride to the rescue? – a proposition so discredited that even the committee chair hastened onward.

The hearing wound down to a clearly rehearsed and well-choreographed five pm break for tea, but not without an “Alice in Wonderland” go-round on the question of the auditors’ issuance of unqualified opinions in the months before the failures of such British institutions as Royal Bank of Scotland, HBOS and Northern Rock.

At the assertion that the auditors actually “performed well” in light of the complex events of 2007 and 2008, adjectives such as “astonishing” and “misleading” were tossed around both in the hearing and amongst subsequent commentators – here.

But why should anyone be surprised?

The pointed observation by one of the Big Four that the auditor does not assess the risk of a business, but renders a report in identical language, whether the leverage of the enterprise is 100 times or none at all – starkly contrasted with a plea from the questioners that an assessment of the “dangers" in a business is precisely, if simplistically, the assurance sought by a wishful user community.

In that context, the fact that the technical reporting requirements were satisfied, to avoid a going-concern qualification – if only through closed-door communications with the Bank of England and the Financial Services Authority – finally exposes the raw insufficiency of the current audit model.

As was equally the case in the 1980’s when the American auditors trailed the emerging catastrophe among the savings-and-loans, the profession lacks satisfactory tools when the regulatory regimes put them to the choice -- whether to qualify their opinions and generate a self-fulfilling prophecy of disaster, or to rationalize a demonstration of the emptiness of the report that constitutes their core product.     

If that much could be taken as established once for all, before everyone went off for tea, then unlike the case with most such posturing displays, the day was not a complete waste.

 

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Goldman's Settlement with the SEC, and the Fragile Future of the Fabulous Fab

Even in the depths of summer, the settlement agreed last month by Goldman Sachs to resolve the charges of the US Securities and Exchange Commission relating to “Abacus,” the toxic subprime mortgage-based derivative, attracted howls of antagonism.  

A reader here called it “total joke” and “a blatant PR splash by the SEC.” Among the bloggers, plaintiffs’ lawyer Jake Zamansky addressed his constituency in high dudgeon, about “letting Goldman off the hook” for “a measly $ 550 million without admitting any wrongdoing”(here). Andrew Ross Sorkin in the New York Times focused on Citigroup’s own $ 75 million SEC settlement (here), but included Goldman’s deal in pointing out that corporate fines come ultimately out of the pockets of shareholders of the offender, not the responsible senior executives.

There’s certainly no need to plead for Goldman. It deftly submitted to an early-stage punishment it could readily afford to bear, from a government agency apparently lacking the stomach for a protracted battle and therefore signaling significant anxiety about its case on the merits.

There are limited options for punishing a corporation – money fines, behavioral monitoring, or the ultimate loss of its right to exist. As only the abstract, legislatively chartered sum of its corporeal parts – directors, managers, employees, shareholders and customers – a corporation is an existential construct that cannot be imprisoned, flogged or otherwise subjected to more personal sanctions.

So for starters, no responsible authority has suggested that the financial sector either in the US or globally would be better off if Goldman had been punished to the point of extinction.

Instead, times have changed. Arthur Andersen disintegrated in 2002 under the Justice Department’s Enron-related indictment – the avoidable and unnecessary result of a series of tragic-comic tactical blunders on both sides. Since then, federal prosecutors in America have treated the financial services sector with the delicacy of Oscar Wilde’s maxim that “a gentleman never hurts anyone’s feelings – unintentionally.”

Consider by contrast the future fate of Fabrice Tourre – the Goldman wheelman on the Abacus deal, who having missed the settlement bus, is now left for road kill.

Did he seek to participate along with the company’s settlement, only to be left as the sole remaining defendant? My calls to his lawyer elicited no response. And the SEC itself never comments on pending litigation. But as reported on August 9, the SEC staff did disclose to the federal court in New York that “very preliminary” settlement talks with Tourre had occurred (here).

It would be inverted logic for the agency to claim a notch on its battle-axe for the $550 million result against the company, yet to view Tourre as such a significant player that it would refuse to negotiate with him. He is simply too small a minnow in the Goldman pool, compared to the big fish the SEC did not even charge, starting with chief executive Lloyd Blankfein and president Gary Cohen.

On the other hand, if Tourre was at the settlement party but could not find the exit under virtually any penalty that left him at liberty, either he or his counsel deserves a whack. Tourre faces a long haul of pre-trial depositions and document production, costly in both funds and emotion. Even with Goldman footing the financial bill, the grind on an individual opposing the forces of government is eventually crushing to the spirit.

Callow and over-stated enthusiasm for his defense position would be no great surprise, but a defendant’s stubborn pride that he was an innocent under venal superiors is a commodity whose value depreciates with the extended duration of a prosecution.

That is, Tourre is a dead man in the industry no matter what. There is now a record against him that includes Goldman’s concession of “mistakes” – although not liability or culpability. Tourre will therefore lose his motions for early extinction of the charges.

So any later settlement window will only open just before a trial, when the SEC will have its engines humming and when an outcome must be worse than anything Tourre could have negotiated at an earlier stage.

Outsiders’ criticisms should only be offered with great care. But it says here that Tourre’s spanking by the SEC is inevitable – so the sooner he bends over, the better.

 

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Goldman Sachs and the Fabulous Future of Fabrice Tourre

Is there a future at Goldman Sachs for Fabrice Tourre? The self-styled “fabulous Fab” was the only individual clipped as co-defendant in the suit by the Securities and Exchange Commission over Goldman’s late 2006 flogging of the exotic financial derivative Abacus, a credit default obligation based on a portfolio of toxic subprime mortgages.

Tourre is now safe-housed in London -- Goldman having evidently taken the strategic decision to keep their erstwhile wonder-boy clasped in close embrace for the duration of its legal exposures. 

For which, by contrast, compare the unpleasant consequential exposures for Société Générale, whose rogue ex-trader Jérôme Kerviel’s just published tell-all, “L’Engrenage, Mémoire d’un Trader”, re-ignites the early 2008 agony of his multi-billion euro infliction; or Arthur Andersen’s ready disavowal and jettison of Enron engagement partner David Duncan, before its own flame-out in 2002.

It would be inductively flawed for Tourre to assume continued enjoyment of his employer’s long-term hospitality. Thanksgiving turkeys, fattening in luxury through the autumn, learn to their dismay of the radical adjustment in their life-style when the farmer’s late-November strategy brings down the axe. Equally, Tourre’s useful life at Goldman is tied entirely to the resolution of its concerns with law enforcement.

So, being well-advised, he should expect to become chum for the sharks either as part of a settlement or directly thereafter.

Unless of course he can prove his present value by re-programming the energy with which he hawked the Abacus product to Goldman’s ready market of credulous believers. 

And how? The British bookmakers have already captured the odds-making on the survival prospects of the Tory/Lib Dem coalition. This year’s action on the NCAA basketball tournament is over. And the consequences of BP’s blown well in the Gulf of Mexico are priced into existing petroleum futures.

Other exotic alternatives? Given the volatility of emerging information about the organized church, arising from Chile to Germany, what about “clerical futures,” tied to the predicted tenure and turn-over of a portfolio of Catholic bishops, or the likelihood of Episcopal schism based on gay ordinations?

Or perhaps a wager on the total first-year sales volume of Apple’s iPad – directly tied to the roll-out of the device itself rather than the prosaic proxy of AAPL’s stock price?

Or here: our cultures now encourage wagers on the duration of life itself, through life insurance, viatical settlements and reverse mortgages -- and pre-nuptial agreements are increasingly used to manage the business side of romantic associations. Do the investment bankers’ innovators not see an unexploited niche market for financial products tied to the durability of marital contracts?

A full range of investment opportunities should be available. A customized wager on the likelihood of the neighbors’ break-up would require frequent re-pricing, depending on the level of loud arguments and broken crockery. By contrast, standardized trades could be tied to the five-year intervals celebrated in the etiquette books – call them “anniversary futures,” denominated wood, tin, pearl, silver, and golden, and priced accordingly.

The records of the domestic courts would also make historical data available to underpin trading opportunities in “marriage pools” -- say, by parish or profession or income level -- with divisions into tranches and risk ratings differentially assigned and priced. 

Consider the risk-disclosure language in the offering documents: triple-AAA ratings for the likely fidelity of a group of unadventurous stay-at-home actuaries – or junk-level assessment for the ten-year prospects of wander-lustful professional golfers or soccer players or elected officials.

These ideas might generate a certain reticence among portions of the investor community. Betting against the probity of the local clergy might infringe some sensitivities. Hard-core adherents to the sanctity of life-long vows might be uncomfortable taking bear positions. But no more so than the occasional unease with the role of short-sellers in the equities markets – recalling that nobody actually forced Goldman’s clients to buy those doubtful-looking CDO’s.

A host of small details would remain to be worked through – whether insider status would extend to clergy or divorce lawyers, for example.

But these are small concerns, and “the Fab” has time on his hands. 

Unless, being smarter than a turkey, he is already busy trading the over/under on his departure date.

 

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How Dangerous is the Two-Billion Dollar Suit Against PwC Over Iceland's Glitnir Bank? The Answer is Blowin' in the Wind

Especially for PricewaterhouseCoopers, the bad news out of Iceland just won’t let up.

First it was the October 2008 collapse of the country’s entire banking system – including its three largest banks – and the departure of their former leaders for congenial places of refuge.

 Then it was the volcano with the unpronounceable name, closing airports world-wide in a demonstration that it is not nice to disregard the forces of nature.

 And on Wednesday came the announcement of a two-billion-dollar lawsuit, brought in New York by the winding-up board of Reykjavik-based Glitnir against its former chairman, chief executive and other leadership, lead investor Jon Asgeir Johannesson, and its auditors PwC -- here.

 It’s an updated reprise of the hitchhikers’ bumper sticker from the 1970’s: “Cash, ash or crash – nobody rides for free.”

 (Okay, for those who don’t remember the original – here.)

 Although asset-freezing orders were apparently issued out of the High Court in London affecting Johannesson’s real estate holdings, those among the individual defendants presently outside the reach of the American or Icelandic legal systems poured scorn on the proceedings – here.

 Bombastic posturing from sheltered jurisdictions will cut no ice with the litigation process in America, however, and PwC itself issued the predictably bland statement (here) about standing by its opinions.

 Well it should, because the days are over when litigation arising out of the non-English countries could be disregarded as trivial, disrespected as the works of immature jurisdictions where outcomes were negotiable against a backdrop of mutual accommodation and inconsequential impacts.

 Instead, PwC faces a real lawsuit (for the complaint, here), in a real court – Manhattan’s New York Supreme – brought on behalf of the bank’s creditors and advised by Steptoe & Johnson and Slaughter & May – real lawyers who know their billions from their millions. Nor, any more than any of the other Big Four accounting firms, does PwC have the resources to absorb a ten-figure litigation blow (here). 

 So the proceeding is mightily more serious for PwC than a few days of flight delays. The Glitnir proceedings show yet again that the world of life-threatening auditor litigation has become as borderless as the skies of global air travel.

 Blowing smoke is not going to make this one go away.   

 

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The Future of Goldman Sachs: Sound, Fury, and the Human Appetite for Risk

 

If correctly read, the thermometer on the temperature of the body politic suggests that the public fever of the last weeks on the SEC’s charges against Goldman Sachs has broken.

A reader expressed her cooled reaction to Goldman’s design of an exotic, tradable mortgage-based product on which the shorts and longs were symmetrically affected: “Why not – after all, that’s what they do!”

It’s not just Warren Buffett's avuncular cheerleading at the Berkshire Hathaway shareholders’ meeting in Omaha, however directly interested, or the related embrace of the mainstream media (for both, see the NYT’s Andrew Ross Sorkin on May 3, here).

More, the brevity of public attention proves again Samuel Johnson’s 18^th century observation that “nothing focuses the mind like a hanging” – whether the present dependent subject is the British Parliament, BP’s oil containment efforts or the Greek noose around the neck of the Euro.

As it moves off-screen, Goldman’s future does not depend on the usually attenuated inter-connections between Main Street and Wall Street. It will lie, rather, in the hands of law enforcement officers, whose reputation enhancement will incline them to nick off a pound of flesh or two and move on to resolution; legislators ready to take up other posturings; and, especially, clients and trading partners whose self-interest will be well served by Goldman’s robust survival.

Which, the more I ponder, is as it must be.

Populist outrage at the business model behind Goldman’s esoteric designs always lack emotional coherence – the unease of those uninformed and unfamiliar with the operation of complex financial products showing again that a little information can be worse than none at all.

As the behavioral academics say, it’s very much to do with how the issues are framed.

For one example: conventional reaction would likely be negative in response to an opinion poll, “Would you support wagering on the length of a human life?”

Yet that is the entire basis for the life insurance industry, which – no less than Goldman’s Abacus product – is in the long run (costs, time value and enterprise profits included) a zero-sum proposition. Large pools of underwriters’ capital wager on the uncertain but ultimate timing of the inevitable mortality of those on whom the bets are made.

And a broad range of legitimately insurable interests are required – it only being frowned upon to allow, for example, the sole care-giver of a fragile elder to take a large policy for his own benefit.

Likewise, while the disconnect between aspirations and responsibilities played no small part in the foundational irrationality of the credit crisis, ownership of a family home has been widely promoted as a virtue. Meanwhile, despite the faint odor of disrepute not unlike that sometimes attached emotionally to short sellers in the equities markets, a niche market for reverse mortgages develops, by which the home equity of aged owners is bought out under pricing based on lifetime occupancy and actuarial expectancy tables.

Even at the personal level, the comparison has always been striking between motorcycle riders in America – who dutifully keep to their lanes although exercising a libertarian right to ride bare-headed – and those in France, for whom helmet compliance is inviolate but so is the chance to careen around traffic and down the dividers.

All of which shows that variations in risk appetites are pervasive, ranging from the ubiquity of casinos and lotteries to the cultural variations in personal safety judgments to the stream of innovations in mitigation techniques – whether product safety devices or hedging derivatives.

So while the particulars of Goldman’s innovations would, and will, outstrip the comprehension of its outsiders – beyond the atavistic spasms of short-term insult at the sheer amounts of money involved – its fundamental instincts are no different from those broadly inherent in the animating principles of human society in general.

In other words, they are part of us.

 

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Valuing Goldman's Next Sh*tty Deal: How About a Little Wager?

  The race is not to the swift, nor the battle to the strong.

-- Ecclesiastes 9:11

But that’s the way to bet it.

--Damon Runyon

 A reader has just asked how, under a cascade of falling knives, Goldman Sachs might shelter itself?

 Media coverage of last Thursday’s Senate hearings tip-toed around the use by Subcommittee on Investigations Chairman Carl Levin (D.-Mich.) of the internal nomenclature of the “sh*tty deals,” like pedestrians in sandals on my dog-infested Paris street.

 The odor of the entire sordid proceedings was unrelieved by the insistence of more punctilious editors on asterisks and euphemisms, nor was the dignity of America’s upper legislative chamber improved.

 Goldman confronts a quartet of threats, of which only the latter two will be serious:

•  The Senate’s orgy of finger-pointing is now old news, supplanted by the BP oil spill, the Times Square car bomb and the British elections.
•  The eventual financial services legislation to emerge from the Congress will be pernicious and misguided, but no less survivable by Goldman than by any other banks.
•  The SEC’s suit over the subprime-mortgage-backed product designed and sold at the behest of hedge fund manager John Paulson, and the potentially broader and more crippling criminal investigation by Justice, will resolve in due course.
•  And, ultimately, there will be a franchise value effect of the verdict to be rendered by the court of public opinion.   

 In reaction to the reader’s query, Goldman might well re-deploy the energy and creativity of its SEC co-defendant, the young hot-shot Fabrice Tourre. The self-styled “fabulous Fab” is now evidently side-lined in its London office – under the classically sound tactical decision to keep him on board rather than throw him overboard into the waiting jaws of the sharks of law enforcement.

 That is, Tourre as a pitchfork veteran around the Goldman sh*t-pile should see the threats to Goldman’s franchise value as both a challenge to new product development and an opportunity to generate both revenue and rehabilitation.

 Namely:

 The street already sponsors talk of a settlement between Goldman and the SEC, which will affect the company’s now-depressed stock price. But why would a simple office pool on the outcome be the only bet? Rather than pursue the mundane approach of speculation in either GS itself or its vanilla options, a creative derivatives engineer would build a whole suite of investment products tied to the timing and cost of the resolution.

 The simplest tradable derivative would be on the straight-dollar over/under of the SEC settlement – the likelihood of a litigated defense victory being as much an unimaginable outlier as, say, the industry’s prior assessment of the collapse of LTCM, Bear Stearns or Lehman Brothers.

 Those interested in handicapping the competing litigation capabilities of the SEC and Goldman’s counsel could test their assessments in the marketplace. Also, Goldman is said to be facing potential legal expenses of up to $100 million – certainly enough to set up a special fund whose performance would be tied to the cubic volume of the court filings.

 Those believing that Goldman is Satan reincarnate rather than the Lord’s messenger could take faith-based bear positions on the outcome, while those cynics who profess skepticism that politics underlie the SEC’s case would do the opposite.

 As for the more threatening criminal proceedings, opportunities arise to speculate on the stability of Goldman’s reputational capital. With the Fab’s proven ability to spin gold out of subprime sh*t, it would be child’s play to devise a “reputational index” that could be traded long or short – perhaps tied to the firm’s movement in league tables or deal flow.

 Subsidiary products could handicap the odds on the most likely individual candidates to be thrown under the litigation bus -- including (probably in inverse order) CEO Lloyd Blankfein, COO Gary Cohn, CFO David Viniar, and the soon-to-be dispensable Mr. Tourre himself.

 What is critical for Goldman, of course, is to capture for itself not only the hedging opportunities but also the vigorish on all this activity, rather than leave anything at the table for the competition.

 Having the inside track on the timing of litigation developments, costs and strategies would seem to require scrupulous care not to be seen as arbitraging its privileged position or trading under conflicting interests. But if its claim to sponsor’s neutrality in the original CDO deal is given credence, Goldman should have nothing to worry about.

 

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